The Tax Factor was created to educate individuals and small-business owners about taxes. Let’s face it, nothing in life is guaranteed except death and taxes. Okay, maybe that sounded pretty depressing but the goal of this blog is to help you find the information to learn how to make taxes work for you. Taxes can be extremely complicated but knowing about deductions and credits can save you thousands of dollars per year.

Oct 23, 2012

I've Got You Babe: Business Partnerships and Taxes

“I now pronounce you man and wife.” These words are associated with great responsibility and commitment. Someone once said “I will remember always that marriage, like life, is a journey not a destination and that its treasures are found not just at the end but all along the way.” You promise to be with your significant other through the good and bad times. You have to deal with your life partner’s annoying habits like always leaving the toilet up or snoring. Man, that snoring habit is a killer! Well my friends, forming a business partnership is very similar to saying “I do.” Partnerships are not immune to life’s ups and downs. You can’t only like your business partner when you’re making a hefty profit. Just like some marriages, forming and ending a business partnership can be very complicated. Before you catch cold feet, we will explain the tax basics of forming a business partnership.

An unincorporated organization with two or more members is generally classified as a partnership for federal tax purposes if its members carry on a trade, business, financial operation, or venture and divide its profits. However, a joint undertaking merely to share expenses is not a partnership. For example, co-ownership of a property maintained and rented or leased is not a partnership unless the co-owners provide services to the tenants.

A limit liability is an entity formed under state law by filing articles of organization as an LLC. Unlike a partnership, none of the members of an LLC are personally liable for the debits. An LLC may be classified for federal income tax purposes as a partnership.

I Love You But Please Sign This Pre-Nup!

In some marriages, it’s probably best to set up a pre-nuptial agreement. Hey, if your future spouse is on his/her third or fourth marriage, just maybe something’s up! You may want to protect your hard earned assets in the case of divorce. The same principle applies to a carefully planned business partnership. Generally, a partnership agreement determines a partner’s distributive share of any item or class of items of income, gain, loss, or credit. The allocations provided for the partnership agreement or any modification will be disregarded if they do not have substantial economic effect. An allocation has substantial economic effect if there is a possibility that the allocation will substantially affect the dollar amount of the partner’s shares of the partnership’s income/loss independently of tax consequences and the partner to whom the allocation is made actually receives the economic benefit or bears the economic burden corresponding to the allocation. Basically, you can’t agree to an allocation to simply to avoid paying taxes. The last thing you want is to explain a shady agreement with an IRS auditor. The auditors will exam your banking information, tax return, books and partnership agreement. It is possible that the auditor can readjust your partnership’s allocation along with penalties and interest.

If a partner’s distributive share of a partnership item cannot be determined under the partnership agreement, it is determined by his or her interest in the partnership. The partner’s interest is determined by taking into account the partner’s relative contributions to the partnership, the interests of all partners in economic profits and losses and the rights of the partners to distributions of capital upon liquidation.

A change in a partner’s interest during the partnership’s tax year requires the partner’s distributive share of partnership items to be determined by taking into account his or her varying interests in the partnership during the tax year. Partnership items are allocated to the partner only for the portion of the year in which he or she is a member of the partnership. If any partner’s interest in a partnership changes during the tax year, each partner’s share of interest, taxes, and payment for services or for the use of property must be determined by prorating the items on a daily basis.

Dealing with Your In-Laws aka “The IRS”

Some married people have the greatest in-laws that are both supporting and loving. However, some unfortunate soul mates wish they only see their in-laws no more than once a year. In a business partnership, I consider the IRS to be the “in-laws” to the business. If you know how to deal with the tax laws then you may have a fruitful relationship with the IRS. Those who fear and refuse to learn our tax system will dread the infamous April 15th deadline.

Partnerships as a business entity are not subject to the income tax. However, a partnership is required to file Form 1065 which reports the results of the partnership’s business activities. Most income and expense items are aggregated in computing the net profit of the partnership on Form 1065. Each partner will receive a Schedule K-1 and include their distributive share on their individual returns (Form 1040).

Each partner must figure his/her taxable income on an accounting period called a tax year. A tax year is adopted when the first income tax return is filed. A partnership must conform its tax year to its partners’ tax years unless the partnership can establish a business purpose for a different period or it makes a section 444 election. Form 1065 must be filed by April 15th following the close of the partnership’s tax year if its accounting period is the calendar year. A fiscal year partnership generally must file its return by the 15th day of the 4th month following the close of its fiscal year.

Did I scare you? Come on; don’t catch cold feet on me now! There’s more basic concept to go over with you.

You Don’t Love Me Like You Used Too!

“We don’t even talk anymore; we don’t even know what we argue about.” Uh oh, if this sound likes your marriage, it may be time to buy some nice red roses or a great divorce lawyer. Yes, just like some marriages, business partnerships must go their separate ways. Partnerships dissolve for various reasons like conflict of views or you just don’t trust the person. Whatever the reason may be, you should know the basics regarding dissolving a partnership. A partnership terminates when all of its operations are discontinued and no profit of any business, financial operations, or ventures in continued by any of its partners in a partnership. Also, a partnership can terminate when at least 50% of the total interest in partnership capital and profits is sold or exchanged within a 12 month period, including a sale or exchange to another partner.

The partnership’s tax year ends on the date of termination. The date of termination can be the date the partnership winds up its affair. In addition, the date of termination can be the date the partnership is sold or exchange that, of itself or together with other sales or exchanges in the preceding 12 months, transfers an interest of 50% or more in both partnership capital and profits.

Are You Ready To Take The Plunge?

Hopefully, I didn’t scare you away from forming a partnership. As I mentioned before, partnerships are very complex and this was just an overview of the basics. I would advise you to do your own research and seek a tax professional. The process is a lot easier when you’re well prepared. A partnership is a marriage between two or more business partners and it shouldn’t be taken lightly. The right partnership can lead to a potentially lucrative situation. You never know how far a business venture can take you unless you take the plunge. I wish you all the luck in your new endeavor.

For more information about partnerships, I suggest reading the following IRS publications located on www.irs.gov:

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About Me

As a federally authorized Enrolled Agent and owner and CEO of the Brooklyn-based J.S. Tax Corporation, Jamaal Solomon provides tax services, business consulting, and IRS problem resolution. Delivering expert service, with his mission to “Take the fear out of taxes” for his clients, Jamaal has prepared federal and multi-state tax returns for individuals, partnerships, not-for-profit organizations, and corporations; has helped numerous tax-exempt organizations with their 501 (c)(3) applications; and has fielded a broad range of client and governmental inquiries on specific returns.
Licensed as an Enrolled Agent since 2007, Jamaal is empowered by the U.S. Department of the Treasury to represent taxpayers before all administrative levels of the IRS for audits, collections, and appeals. As part of the Enrolled Agent program, Jamaal completes an average of 24 hours of continuing professional education each year. He earned his MS in Taxation from CUNY Baruch in 2009 and a BS in Business Management from SUNY Stony Brook in 2002.